Stocks are far less risky than you think

The advantages of sticking with equities over the long haul

Most people try to reduce risk in their investment portfolio by seeking safe havens like bonds, or by moving money out of the parts of the market that scare them at any given moment.

But what if the best way to minimize risk was to simply buy and hold stocks for the long run?

In a world where many investors seemingly have given up on the idea that buy and hold can work, some new research from two college professors and the head of retirement research for Morningstar Investment Management suggests that stocks become less risky the longer you hold them, research which suggests that “set it and forget it” could be pretty good investment advice, and that you should overweight your portfolio toward stocks, even as you age and most people are becoming more conservative.

It’s important to note that David Blanchett of Morningstar, Michael Finke of Texas Tech University and Wade Pfau of the American College were not talking about holding any specific individual stocks for the long haul, just indexes or baskets of stocks. As Blanchett noted on my radio show this week, “I wouldn’t recommend just going out and buying [General Electric]
GE, -1.39%
, I’d recommend buying a broad index.”

There are a lot of reasons why some investors, intuitively, believe that stocks are inherently more risky the longer you stick with them. For starters, there is the idea that the longer you stick with a portfolio, the more market gyrations, downturns and corrections you will live through. You’re strapping yourself to the market rollercoaster, which does not guarantee that it will be up—or even back to your starting point—when the time comes that you have to get off.

The longer you are in the market, the more uncertainty you face—especially in today’s wacky socio-economic and political climate—and plenty of folks translate “uncertainty” as “risk.”

Then there’s the basic idea that if the market becomes less risky over time, it would create what amounts to a free lunch for anyone who sticks around long enough to enjoy it. For anyone who believes in “efficient markets,” that’s anathema; the market is supposed to finds those edges and advantages and exploit those strategies until they are useless and dead.

The concept behind the new research involves “time diversification,” an idea that experts and academics argue over, with some suggesting it’s real and powerful and others saying it doesn’t exist.

You’ve heard of diversifying into different asset classes and across the international landscape and more, but time diversification simply suggests that the longer holding period effectively diminishes the effect of any short-run period, as has happened to folks who rode out the financial crisis of 2008 by sticking with the market through its ups and downs to get to its recent highs.

In short, investors are more risk-averse—they want to feel certain of bigger returns—during downturns and recessions, but are willing to accept more risk when the market is growing, and time diversification assumes that these swings will even out.

“One would think that in theory holding a diversified portfolio of cash, bonds and stocks creates the most amount of wealth 20 years from now,” Blanchett said. “That actually isn’t the case. If you look back over history, holding stocks over the long haul has been the optimal thing to do…and this effect of time diversification has actually been increasing, so the benefits to long-term investors have been growing over the last 110 years, not shrinking, so holding equities is actually a better and better thing to do.”

The research does not change the fact that there are still going to be good and bad times to buy stocks, it simply points out that investors benefit from being more aggressive—in the broad mix of stocks/bonds/cash, it suggests going more in the direction of equities than you might otherwise have been leaning—and from hanging on.

It’s worth noting that the research covered 20 countries and over 100 years in those markets, and that it does not suggest investors give up on diversification—internationally, by company size and more—nor does it suggest that investors ignore personal factors like time horizons that create short-term needs that make sticking around for the long-run impossible.

While Blanchett noted that economists might call doing a little of each strategy irrational if you believe the research that shows long-term providing that free lunch, he noted that doing a bit of each—having some very long-term money for part of a portfolio and another portion for short-term, trading-oriented activities—probably would make many people comfortable.

That said, the new research gives investors who had been hearing, feeling and otherwise thinking that buy-and-hold investing is dead a big reason to feel like maybe their investment philosophy has more merit than it has been given credit for.

It also gives them a reason to tilt their portfolios toward equities, despite the nervousness most investors have been feeling toward stocks since the turn of the century.

“The longer your holding period, the more aggressive you really can and should be. For an investor with an infinite time horizon—let’s just say 20 or 30 years—probably the lowest risk long-term investment for that investor is actually stocks,” Blanchett said. “Throughout history, holding a portfolio of all stocks has actually been less risky of all cash, if you look at the final income value after 30 years.

“The kicker is that people tend to look at their account statements on some regular intervals and they feel that pain long-term,” he added. “But really if you were going to buy something, put it in a lockbox and then come back and check it 20 years from now, hands down that would be stocks.”

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